Is Your Emerging Markets ETF Actually Emerging?

It’s time to redefine which countries are emerging markets, and this ETF hits the nail right on the head

To say that emerging markets have been all the rage since 2003 — when it became clear the United States and most other well-developed economies were no longer sure things — would be an understatement.

Many of these countries were entering their economic heydays with such velocity that they looked capable of overcoming the global malaise. And the iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO) have both grown their asset bases to more than $40 billion in the wake of emerging markets mania.

A lot can happen in 10 years, however.

That includes which countries are even classified as “emerging”; many of them are now fully “emerged.” The problem is, the fund industry in many cases has been slow to update their EM holdings to reflect the global economy’s 10-year transition.

So … are you sure that your emerging markets fund is doing its job?

Time to Recategorize Emerging Markets

A word to the wise: China is hardly an emerging market any longer. It rivals the U.S. as the world’s dominant single economic superpower, and other countries are just as eager to trade with it as they are with the U.S. And yet, it’s the single-most represented country in both the iShares and Vanguard emerging markets ETFs; Chinese stocks make up 18% and 21.5% of their respective portfolios.

Not that there’s no opportunity in Chinese stocks. Even though China’s economy growth rate has slowed over the past five years, that reduction from has been from a stunning 10% then to a still-amazing 7% now.

But that cat’s well out of the bag — everyone knows about China now.

And it’s not like China’s now-misplaced outsized allocation is the only proverbial square peg in a round emerging market hole.

For instance, Brazil accounts for 14% of VWO and 11% of EEM — and that’s also off-base from an emerging markets perspective, as Brazil is now the world’s sixth-biggest economy (by GDP), displacing the United Kingdom.

South Korea and Taiwan are also well-represented by most emerging markets funds, and while you could argue both still are emerging market-esque, that’s still pushing the envelope.

Those are hardly the only examples of countries that would surprise investors to learn how big and progressively developed they really are. Case in point: Indonesia. Contrary to popular belief, Indonesia is anything but a third-world nation just now picking up on electricity and telephones. Indonesia is the world’s fourth-biggest country by population, it’s the sixteenth-largest economy, and it’s home to the world’s fifth-greatest number of Facebook (FB) users.

Point being, if you’re holding an emerging markets fund to capitalize on high-growth opportunities that few others recognized, that ship has largely sailed for the most heavily owned nations within most EM funds’ portfolios. Anymore, an investment in those ETFs is an investment in a country closely linked to the United States’ economy.

Most of the countries that make up the index would be difficult for the average person to locate on a map, and those that aren’t “frontier markets” (an even riskier but even more growth-oriented classification) fit the true definition of “emerging market.”

“An emerging market country is a society transitioning from a dictatorship to a free-market-oriented-economy, with increasing economic freedom, gradual integration with the global marketplace and with other members of the global emerging market, an expanding middle class, improving standards of living, social stability and tolerance, as well as an increase in cooperation with multilateral institutions.”

That’s certainly not China. China is as much of a global commerce hub as any other country. Its middle class is now officially a consumer class, and at its current pace will soon be China’s key source of economic growth. Ditto for Brazil, and to a lesser degree, South Korea. They’ve all pretty much emerged.

Argentina, Kazakhstan, Vietnam, and several other smaller nations that are well represented in the Global X Next Emerging & Frontier ETF, on the other hand, are just now starting to experience the “a-ha” moment Kvint described. Indeed, Global X specifically describes this fund’s holdings as investments that go beyond the BRICs (Brazil, Russia, India and China) and beyond the most developed tier of emerging markets, which means countries like South Korea and Taiwan are also excluded.

As for putting the potential growth of the new emerging markets in perspective, the Global X fact sheet for its new ETF provides some eye-opening stats. The most salient ones are:

Countries represented in the (Solactive) index represent 24% of the world’s population, but just 12% of the world’s GDP, and only 8% of the world’s equity market cap.

Frontier markets not only have low investment-performance correlations to developed economies’ stock, but even show low correlations among their emerging market peers.

Emerging and frontier markets are home to younger populations that are growing faster than their developed peers. These economies tend to offer more competitive labor forces better positioned to become the world’s next big suppliers of inexpensive labor.

Granted, the data nuggets are self-serving for the Global X fund, but they’re accurate points nonetheless. There’s a lot of “catchup” potential from these markets, and that means outsized growth for the fund’s investors for at least several years (not unlike the strong growth we’ve seen from the arenas that were considered to be emerging markets 10 years ago).

Bottom Line

It’s time to start rethinking, in a deeper way, exactly why we take on emerging market exposure, and how we go about doing that. The Global X Next Emerging & Frontier ETF is a step in the right direction.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.